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Looking below the surface

What factors other than stock market performance influence the health of a company pension scheme? Anne-Marie Winton, Partner, ARC Pensions Law LLP, writes.

Rather like sharks and icebergs, defined benefits pensions liabilities can lurk scarily underneath the surface of a company’s accounts, with the potential to damage or sink the business.

Put simply, a defined benefits pension scheme is a contingent liability of the employers participating in the scheme, with the size of that liability (the deficit) being the difference between the scheme’s assets and liabilities at any time. That deficit can be highly volatile as the difference between two large numbers, and for a scheme that is closed to accrual of benefits (as most are), responsibility for meeting it over time lies solely with the employers.

The market value of the scheme’s assets can generally be easily determined, but how the liabilities are valued varies depending on who you ask. Group accounts do this calculation on a “best estimate” basis consistent with accounting standards, but this will give a different figure to the liabilities “prudently” determined by the scheme’s actuary acting for the trustees. Yet another, far larger, “solvency estimate” of the liabilities will be given on winding up the scheme by providing annuities with an insurer. A pensions lawyer, if asked, may advise that the actual legal liabilities are greater than any that these people thought due to hidden defects in the drafting of the benefits structure. For example, it is not uncommon for schemes incorrectly to have equalised benefits for men and women. Often, an attempt to equalise has been made more than a decade ago, but that attempt was defective in some way, so the deficit is larger than expected (i.e. an additional contingent liability of the employer) and there may also be underpaid pensions that the scheme (funded by the employer) needs to top up.

Liability for past service benefits built up to date is calculated by estimating the future cashflows needed to meet those benefits, taking into account assumptions on: future inflation rates for pension increases and revaluation of deferred benefits; how long scheme members will live; whether a spouse’s pension would be payable on their death (and the age of that spouse); and how much cash members take on retirement. Those cashflows are then discounted back (typically using assumptions on bond yields, though the scheme actuary can use the expected actual asset returns) to set out an assumed rate of return that would be earned on the scheme’s assets.

The scheme actuary must by law include a margin for prudence in their assumptions, whereas accounting standards require directors, with actuarial advice (not necessarily from the scheme actuary), to set assumptions on a best estimate basis. It is this difference in approach that means that the deficit disclosed in the employer’s accounts can be highly misleading. A more realistic assessment of an employer’s contingent liability is the deficit agreed between employer and trustees every three years in the scheme’s valuation using the prudent actuarial assumptions. And this valuation deficit is also used to agree the level and duration of annual employer contributions to the scheme.